The State of Credit

The Milken Global Conference kicked off this morning with a panel moderated by Mike Milken on the only possible subject: credit. It was a high-level panel, with some high-level discourse: one of the most sophisticated conversations I’ve ever tried to follow at 8 o’clock in the morning.

Wes Edens, the CEO of Fortress Investment Group, kicked things off by pointing out how much worse this credit cycle is than were previous downturns in 1998 or the beginning of 2002: rather than widening out to 70bp or 80bp over Treasuries, investment-grade bonds are now trading at 1200bp over. And a lot of that, he said, isn’t necessarily credit risk: "the bulk of it has been due to a tremendous liquidity crisis". Think for instance of the effect of SIVs unwinding: that’s $300 billion or more being sold into a market with precious few buyers, with the obvious effect on prices. "It’s what happens when the buyers of the assets all become sellers of the assets," said Edens.

Rajeev Misra, head of credit trading at Deutsche Bank, agreed, and said that the reason emerging market debt has been the best performer of late is simply because of the lack of leverage in the asset class. He’s also convinced that there’s an enormous cash/CDS arbitrage in the investment-grade space, where cash bonds yield 70-80bp more than the yield on the CDS. There’s no default or credit risk in this trade, he says, and those bonds are going to mature in 5 years: the spread is a pure liquidity premium. When massive spreads like that don’t get arbitraged away almost immediately, you know that financial markets are going through unusual times.

Misra also pointed out an enormous asymmetry in the world of subprime credit default swaps. Hundreds of billions of dollars of BBB-rated subprime CDS were bundled into synthetic CDOs, he said, despite the fact that the BBB slice of a subprime RMBS is only about 2% of the total. If total subprime bond issuance was $700 billion, then all of those credit default swaps – which were then structured into hundreds of billions of dollars of AAA paper – were based on maybe $15 billion of actual bonds. And that’s how a tiny number of very risky bonds can, through the magic of structured finance, underpin huge quantities of nominally risk-free debt.

Noel Kirnon, of Moody’s structured finance group, seemed a little more slippery. He said that historically structured finance ratings have been more stable than corporate ratings, and that even today structured finance in 2007 has been much less volatile than corporate debt was in 1986 – a period of time I’m sure that Milken remembers very well indeed, and never thought he’d end up reliving.

I suspect, however, that the lack of ratings volatility that Kirnon referenced is a product of the fact that corporates have to be continually re-rated because they are continually issuing. Structured products, by contrast, generally get rated only once, and it takes a lot for a ratings agency to re-rate them without any new issuance from that specific entity.

Steven Tananbaum, the CEO GoldenTree Asset Management, was reasonably constructive. One thing he pointed out is that there’s no difference between mean and median bank-loan prices, in stark contrast to the last credit downturn. Back then, most credits performed, while a few plunged in price. Today, there’s no differentiation between credits – probably because so far default rates have remained extremely low. Inevitably a large number of credits are not going to default: if you think you know which they are, there are some very attractive yields out there right now.

That said, however, spreads are still narrower than they normally are when default rates pick up, which means we’re still early in the credit cycle and spreads are going to widen further when companies start to default. When the default rate does rise, there might well be further spread widening, even on the good credits which ultimately will continue to perform.

One interesting datapoint Tananbaum did come up with was that implied default rates on double-A loans are actually higher than implied default rates on single-A loans. That, he said, is a result of the deleveraging going on: the purchasers of AA tranches were all levered 10x, and are now being forced to unwind. On the other hand, you can only calculate implied default rates by assuming recovery values, and Tananbaum assumed higher recoveries on AA than on A loans. That might well not be the case, this time around.

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